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Is Your Dollar Worth More Today?

Let’s imagine we are given a marshmallow and asked to wait for 10 minutes to get another one under the condition that we do not eat the original marshmallow.

The test in images:

The Marshmallow effect in our neurons!

Adults are rarely much more mature! We tend to prefer immediate reward than future rewards, even if the future rewards are higher. Many experiments have shown that most animals have the same behavior. Neural correlations have been found through various fMRI experiments to give a biological explanation of this biased behavior. Most of the time, participants have made a series of choices between immediate and future monetary reward while researchers were studying the activation of their brain. They found that when making such choices, let’s say between winning 10 dollars today or 20 dollars in three months, two parts of our brain were competing.

Our parietal cortex, especially sensitive to numbers, time and space magnitudes, ”wants” to be rewarded immediately while our striatum, in charge of reward evaluation, ”wants” the higher reward. For many of us, the parietal cortex has the advantage over our reward system so that we prefer a lower immediate reward rather than waiting to get a better one.

How to model our inter-temporal choices?

Inter-temporal choice is the study of the relative value people assign to two or more payoffs at different points in time, like getting one marshmallow right now or waiting to get another one. Most choices require decision-makers to trade-off costs and benefits at different points in time. In one of the major contributions to behavioral economics, Loewenstein and Prelec (1992) set the foundation for this behavioral approach to decision making over time. Several models have followed (Laibson, Samuelson, Ebert and Prelec…).

1. They found that we do make the same inter-temporal choices in the case of gains or losses. If we have the choice between paying €300 now or €400 in one year (supposing that we do not invest this money) , we will tend to postpone this unpleasant event even if we have to pay more later. On the contrary, as for the children in the marshmallow experiment, we will prefer to get the €300 now rather than waiting one year to get the €400.

2. Moreover, contrary to classical economic models, we do not discount time following an exponential but rather a hyperbolic curve which depends on our level of time sensitivity and impatience. Here are how these two parameters are taken into account in a time-discounting model by Ebert and Prelec:

a is the impatience indicator
b is the time sensitivity indicator.

With b=1 being the classical exponential time discounting model

What is the impact of cognitive time discounting on our business decisions?

Most investment decisions are made for the middle or long run. Investing in a stock, in an acquisition, or in an industrial project is betting on the future. When building strategic plans and prospectives, cognitive biases related to time discounting should be take into account as much as possible to better capture what managers really expect from their investments.